Anatomy of SAFE

More and more startups these days are using the Simple Agreement for Future Equity (“SAFE”) option to raise funding. This agreement has not been around all that long, and many investors do not fully understand what it is yet. There are benefits and risks associated with investing in SAFE.

In this blog post, we aim to educate investors about the pros and cons of SAFEs. We start with explaining what a SAFE is, how does it work, what are the critical elements to watch out for, the different type of SAFE options available, benefits of SAFE for investors, and finally the knowledge one should have about SAFE and private equity before moving forward with an investment decision.

What is SAFE?

SAFE is an acronym for Simple Agreement for Future E quity. Y Combinator developed this term in late 2013 as a way for entrepreneurs to get their money immediately and investors to receive ownership in a company at a future date.

The agreements are usually only 5–10 pages long, so it is a concise document that connects an investor with a startup which is looking to raise funds immediately.

As an angel investor, you may receive equity in the future, as long as the triggering event occurs. The draw for the entrepreneur is, of course, that they are not giving away stock in their company just yet. It also puts off the need for them to assign a valuation to their company in the early stages.

How does SAFE work?

SAFE allows an investor to purchase shares in a future round at an undetermined price. The company using this option is usually in the very early stages of funding. Because a SAFE allows the entrepreneur to raise money, now without having to determine a share price, it makes it easier for them to get up and running when their company does not yet have much value.

The investor purchases the right to convert their investment into equity in the future, as long as the pre-agreed trigger event occurs. This is usually the first priced equity round, but it could also be the sale of the company.

The number of shares you, as the investor, receive will be based on how much you invested and the share price of the next round or the liquidation event. However, because you agreed on the triggering occasion before your investment, you will at least have a rough idea of when this event will potentially occur. There is however no guarantee that this triggering event will occur.

Critical Elements in a SAFE

Four primary terms will affect how a SAFE converts to company shares. These are the things you will want to fully understand before making your investment. While these are not the only elements of a SAFE , they usually have the most significant impact on the future of your investment.

Some SAFE options apply a discount of between 10% and 30% to future equity. As an example, if your triggering conversion event is the next round of equity, your discount is 10%, and the share price is marked at $20, you will be able to purchase those shares at a discounted rate of $18.

Negotiating a discount means you are buying the shares at a lower cost than their current value. For example 100 shares would cost you $1800 rather than $2000 therefore lowering your cost basis.

Valuation Caps

A valuation cap is the maximum price you would pay for your shares, regardless of what the next equity round is priced at. The valuation cap also limits the price that you will pay for your shares.

Most-favored Nation Provisions

This term is applied when more than one SAFE option is being offered to investors. If you have invested in a SAFE and the company raises another, they are required to inform you of the terms for the following SAFE. If you think the new SAFE has better terms than the one you are currently holding, you have an opportunity to request the same terms.

Pro-rata Rights

If you negotiate pro-rata rights as a part of your SAFE, you can invest extra funds into the company at the time of the triggering event to maintain your percentage of your ownership in the company.

Types of SAFE

There are four basic types of SAFE:

• A valuation cap with no discount
• A discount with no valuation cap
• A valuation cap and a discount
• No valuation cap or discount

Which option is best for you depends on your specific investment goals and objectives as well as your faith in the company’s future. With both a discount and a valuation cap, you have a better chance of increasing your ownership for less money without the company over inflating its valuation. Without a cap or a discount, you would pay more for your shares when the trigger event occurs.

Many SAFE options fall somewhere in the middle when it comes to these terms. The investor should choose a SAFE which includes these terms before investing. With a valuation cap in place, the company maintains a reasonable valuation, and there is a lower risk of an undervalued exit.

How SAFE Functions for Investors

So, what are the benefits for you as an investor? Well, at its core, a SAFE rewards you for investing early. You have the potential to own more of the company and pay less for that ownership than others who invest later.

Key Impacts of SAFE

These are early-stage companies with no current valuation and the future of the company is unknown. Startup companies involve risk and there is no guarantee that they will be successful. There is no guarantee that the trigger event will take place. Investors also need to keep in mind that a SAFE option is high risk and is not liquid. Before investing in a SAFE , an investor needs to evaluate his/her personal risk tolerance and liquidity needs.

What happens with many startups is that they will generate a SAFE in the beginning, to avoid giving their company a valuation or having to determine a share price too early. But in some cases, they continue to create these SAFE options when they need more funding rather than raising an equity round.

Startups can keep pushing the valuation farther down the road, so that they do not end up selling off more of their company than they intended. Additional funding rounds can also lead to dilution, meaning your investment is not worth quite as much as you were hoping. You also need to keep in mind that you could lose the entire amount that you have invested.

You may also find that entrepreneurs offer SAFE because they are unsure of the future of their company. They need actual money now to develop their ideas and vision of what the company could be.

While the advantage to the entrepreneur is that they can defer the valuation of their company to a later date, this may be bad news for you — the investor. You do not know what the company’s future holds, and you will not know how much of it you own until that next round takes place. Your funds are also not liquid.

If you see the need for what the company has to offer, a SAFE may be a good idea if you have a high risk tolerance and do not have any liquidity needs. There are many terms you may be able to negotiate to be more advantageous in the future, and that is why the SAFE was created. While they are easy for early-stage companies to set up, there are also potential benefits to the investor.

What You Need to Know About SAFE and Private Equity

While many issuers have hopped aboard the SAFE train, it is up to you to decide if you should participate or not. There are a few key things you should know about SAFE before you choose.

1. It is not Standard Stock.

By getting into a SAFE on the ground floor, you do not own any part of the company, and you do not have any shareholder rights. You have an agreement that if the terms of the SAFE are met, you can purchase equity at that time. There is a large amount of risk associated with this structure as there is no guarantee that you will ever receive equity in the company.

While it can potentially pay off, you need to know upfront that if the terms of the SAFE are never met, you will not see that money again. In other words, the total amount you have invested could be completely lost. The founders could go bankrupt or be unable to raise another funding round.

2. They are not all the same.

While the SAFE was developed to be short, straightforward, effective, and easy to understand, every SAFE option is different. The terms you negotiate will vary every time, and every company uses different language to describe a triggering event. You need to make sure that you understand the terms prior to investing.

The provisions of your conversion and the price may be treated differently from one issuer to the next. Make sure that you read and understand your disclosure statements and the terms of the SAFE before investing.

3. Understand the triggers.

Many different scenarios can trigger a SAFE conversion as outlined by the Securities Exchange Commission (“SEC”). They could include the next raise, an acquisition, or an IPO. It is essential to understand how these triggers work and how they affect you.

4. The conversion may never be triggered.

In some cases, no trigger is activated, and you get nothing in return. If the company you invested in, has enough revenue and cash flow to avoid ever raising money again, and this raise is your trigger, you are out of luck. If another company never acquires it, you will not get your money back because you don’t own any part of the company. These are high risk investments and it is very possible that you lose the total amount that you have invested.

5. Know the terms and your rights.

While you may not yet own any part of the company, you may have other rights, like repurchase rights or dissolution rights. You need to know what happens to your money if the company dissolves or someone else wants to purchase your rights to future equity. It is always important that you understand the terms and risks prior to investing and that you are prepared to lose the full amount invested.

Final Thoughts

SAFE was created for ease at both the founder and the investor level, but the benefits and risks are very different for both parties. As an investor, it is critical that you understand how a SAFE works and when you should use it in your investment portfolio.

SAFE can be complicated for even a seasoned angel investor because it is relatively new. It is important to learn more about becoming an angel investor before ironing out the details of your chosen investment vehicle.

A SAFE can potentially provide you with more ownership at a lower price, but the conversion trigger may never take place, leaving you with nothing. You need to consider all of the benefits and risks prior to investing.

Originally published at https://www.propelx.com on June 28, 2021.